by Justin Pawl, CFA, CAIA
(Entry #10 in a series on Behavioral Finance)
The results of an election. The 9th inning home run to win the game. The stock a friend told you was a sure thing falling by 50%. Each time is different, but in situations like these in our lives, most people hear themselves saying, “I knew it all along.”
Of course, we didn’t really know it all along. We only felt that way once the event had happened. This phenomenon is what psychologists call hindsight bias, and it’s the tendency for people to see events that already occurred as being more predictable than they were before they took place.
There is in-depth research available on this topic as it’s one of the most widely studied behavioral biases today. There are three types, or levels, of hindsight bias:
- Memory Distortion – People have imperfect memories, and our brains fill in the gaps with information that confirms what we now know to be true. For example, people regularly fail to recall earlier opinions or judgments about an event that are counter to the outcome. “I said it would happen.”
- Inevitability – Our belief, after the event has occurred, that the event was inevitable. “It had to happen.”
- Foreseeability – Misplaced self-confidence that we could have foreseen the event. “I knew it would happen.”
In isolation or combination, these facets of hindsight bias cause people to assume the outcome they ultimately observe as the only outcome that was ever possible. The flip side is that people underestimate uncertainty in general, and specifically the outcomes that could have materialized, but did not, with specific events.
Regardless of the details behind hindsight bias, the reality is that hindsight bias prevents people from learning from their experiences. After all, if you think you “knew it all along,” why would you examine your decision-making process for coming to that conclusion?
Source: Josephine Elia
As you can imagine, hindsight bias can be brutal when it comes to investing successfully:
- When an investment does well for none of the reasons envisioned initially, hindsight bias can cause investors to rewrite history (and their investment thesis) to conform with the positive developments. As such, the events are mistakenly viewed as predictable, which leads to false comfort in one’s predictive powers resulting in excessive risk-taking.
- Likewise, when an investment does poorly, hindsight bias causes investors to forget other situations in which their forecasts were wrong because it’s embarrassing and/or difficult to admit errors. Instead, they chalk-up the loss to “bad luck.” This self-deception makes the investor feel better in the moment, but it also prevents him from doing the hard work of examining his decision-making process. Thus, he becomes susceptible to making the same mistake in the future.
As the two examples above highlight, hindsight bias works against you in both winning and losing investments. It’s pervasive, but it’s addressable. Similar to the previous bias we discussed, representative bias, an effective strategy to rooting out hindsight bias, is to use an investment diary to record your investment thesis and expected outcome. Examining variances from your initial written expectations can uncover systematic forecasting errors in your process. Another useful approach is “to consider the opposite.” That is, think about outcomes that didn’t happen but could have happened. This exercise isn’t easy, but it’s effective because it forces us to counteract our typical inclination to disregard information that doesn’t fit with our beliefs (or in this case, facts).